When variation margin attacks: Difference between revisions

Any of the standard reference works<ref>Goldsmith, Armitage & Berlin, ''Teach Yourself Law'', Book IV; The Open University Criminology Course, Part I; The ''Perry Mason Book For Boys'', 1962, [[Aleebee|needless to say]].</ref> will tell you that [[variation margin]] is a good thing, apt for ridding the world of the kinds of systemic risk that have the habit of building up in the financial system.

 

Since, like Captain Redbeard Rum, your correspondent is going to run against what all the other captains will tell, you, let us set the scene with a story.

Now here is an interesting thing. Because [[Archegos]] gained their market exposure using [[Equity derivatives|swaps]], ''by regulation'', their swap dealers were ''obliged'' to pay out their realised gains<ref>For [[prime broker]]<nowiki/>s charging “[[dynamic margin]]” this was partly offset by the effect of increased [[initial margin]] required on the inflated value of the position in question; for those charging only a [[static margin]] amount, there was not even that fig-leaf. </ref> or “[[net equity]]”, every day, in [[cash]], in the form of “[[variation margin]]”.  To be sure, the broker usually pays [[VM]] into a bank account it runs for its client. There are withdrawal thresholds that apply to that account that takes into account required [[initial margin]] — oh, that’s another story altogether — but over those thresholds all the variation margin is the client’s money, available to be withdrawn on request.  

This is completely normal in the world of latter-day [[Derivative|derivatives]]: mandatory two-way exchange of [[variation margin]] was implemented by regulation in pretty much every major market ''in the name of reducing systemic risk'' — but all the same, in the context of [[Archegos]], it does look weird. It is like ''forced'' [[swap dealer]]<nowiki/>s to extend additional lending against asset appreciation, regardless of the likelihood that the asset might then ''de''preciate again. Imagine if your bank, by law, had to pay you the cash value of any increase in your home’s value over the life of your mortgage.

Had Archegos put the equivalent ''physical'' positions on, using [[margin loan]]s, its [[prime broker]]<nowiki/>s would ''not'' have ''had'' to advance it the cash value of its [[net equity]]. Now to be sure they may well have ''willingly'' done so, of course – lending on margin is how [[prime broker]]s make their money after all — but being ''able'' to lend money, and being ''obliged'' to lend money are quite different propositions on that special day when it seems the whole world is going to hell.<ref>It is fair to note that — with the possible exception of the vampire squid — [[Archegos]]’s brokers did ''not'' believe the world was going to hell, at least not until it was far too late. But the principle remains.</ref> And the more precipitately a position has gone ''up'', the more likely it is to come precipitately ''down'' again.

So there is this [[dissonance]], between [[Cash prime brokerage|''physical'' prime brokerage]], where lending money against [[net equity]] is at the [[prime broker]]’s discretion — oh, sure, you may withdraw your [[net equity]] at any time, but you have to take it [[Payment in kind|in kind]]<ref>Withdrawing [[net equity]] in the form of the [[shares]] themselves, rather than their [[cash]] value, has a very different effect on the [[prime broker]]’s risk profile. It makes the client’s portfolio ''less'' volatile; withdrawing [[cash]] makes it ''more'' volatile.</ref> or liquidate your position, if you want it in cash — and [[Synthetic prime brokerage|''synthetic'' prime brokerage]], where cash payment of that value of that net equity — in the swaps world, known as “[[variation margin]]” — is required by regulation.

 

That’s worth dwelling on: if you liquidate your position, sure you get all your cash, but you go ''off risk''. If the market tanks the next day, happy days all round. You’ve closed out your stake and taken your money off the table. With [[variation margin]], you get to keep your stake ''and'' take your money off the table.  

Since this is required ''by [[Regulatory margin|co-ordinated world-wide regulation]]'' for swaps, it doesn’t take great imagination to read across to physical positions since they are, to all intents and purposes, economically identical. “Hang on a minute,” clients and their [[Buy-side legal eagle|advisors]] will say, “if you have to pay out my cash equity value under a swap, why can’t I have it for an equivalent physical position?”

On its face, this is a fair question, to which the answer is either: “Huh. I hadn’t thought of that. Yes, I suppose you are right. Here you go!” — call this the “all other captains” argument; or: “Well that just goes to show what a misconceived idea compulsory two-way [[variation margin]] is. There’s no way on earth I’m automatically paying out your equity in cash” — call this the “Redbeard Rum” argument.

The [[JC]] prefers the Redbeard Rum argument.

“Come on,  [[JC]]: I know you are a cranky old bugger. But do you really mean to say you are going to swim against the tide of all that consensus?”

Allow the cranky old fellow to launch his languid socio-historical explanation, and please indulge him, by pretending he would not instantly be cut off, mid-sentence, like so: “all right then: if you won’t give me cash for my physical longs, I’ll just put them on swap.”    

In the good old days — in the time of the [[Children of the Forest]], before the [[First Men]] — the overall vibe of the financial system was circumspect, self-imposed ''[[prudence]]'': musty institutions, staffed by Captain Mainwaring-types, providing stodgy, unflamboyant loan facilities and broking services to clients who were grateful to be offered them, and who would produce whatever sureties their banks required as a condition to being allowed to do business.   

The financial services industry cleaved, basically, into two types of participant: ''intermediaries'' and ''customers''. We have waxed [[Look, I tried|elsewhere]] about the countless ways businesses can contrive to interpose themselves into a process that oughtn’t to need ''that'' much intermediating, but let us, for today’s outing, take it as we find it.

There are lots of types of intermediary: those who comprise market infrastructure: [[Exchange|stock exchange]]s, [[clearing system]]s, securities depositories and so on; those who earn only a [[commission]] from their involvement, and take no [[principal]] risk<ref>I include here “[[quasi-agent]]” roles that are conducted on a [[riskless principal]], but (absent insolvency) are economically neutral: thse participants are remunerated by [[commission]] or fixed [[mark-up]] and do not have “[[Skin in the Game: Hidden Asymmetries in Daily Life - Book Review|skin in the game]]”.</ref>: [[Cash brokerage|cash broker]]<nowiki/>s, [[Investment manager|investment managers]], [[Clearing broker|clearer]]<nowiki/>s, [[Market-maker|market-makers]] and [[Intermediate broker|intermediate brokers]]; and those who ''do'' take principal risk, but only by lending to their customers, and generally don’t participate in the upside or downside<ref>Barring through “gap loss” where, due to portfolio losses, the customer is insolvent and cannot repay its loan.</ref> of the investments they are financing: [[Bank|banks]].

All of these intermediaries have one thing in common: their remuneration does not depend on how their customer’s investments perform.<ref>Unless they perform ''so'' badly they cause the customer’s bankruptcy.</ref> Intermediaries do not have [[Skin in the Game: Hidden Asymmetries in Daily Life - Book Review|skin in the game]]. They are not supposed to lose ''any'' money, let alone billions of dollars of the stuff.

Customers, of course, ''do'' have skin in the game: they take all the benefits — less their intermediaries’ fees, commissions and financing costs of course — and are first in line<ref>Of course, if the investors should run out of sponges, or their buckets are all full, while there are still some losses left to go round, these get passed to the poor [[Bank|banker]]<nowiki/>s and [[Intermediary|intermediaries]] who may still be owed something. This is why we say investors have a “[[first-loss]]” risk: once they have been wiped from the horizon, any remaining losses go to the investors’ [[Creditor|creditors]], who thus have “[[second-loss]]” risk, whether they like it, or even know it, or not.</ref> to absorb all the losses of their investments. They may be [[Professional client|institutional]] (pension funds, investment funds, multinationals) or [[Retail client|retail]] (private investors) and while the range of investment products they can invest in will depend on their sophistication and financial resources, they are not usually not subject to any kind of prudential regulation. They can, and do, blow up.  

More speculative investment vehicles like [[hedge fund]]<nowiki/>s may be highly [[Vega|geared]] and quite ''likely'' to blow up. This is where intermediaries have some [[second-loss]] tail risk: if the customer has blown up, the intermediary loses anything the customer still owes it. Investment funds have ''no'' capital buffer. When they “[[Gap-risk|gap]]” through zero, their counterparties absorb ''all'' their market risk, despite wishing to have none of it. [[Broker]]s, banks and and [[dealer]]s ''do'' have a capital buffer, and if their clients’ positions gap through zero, can usually absorb losses, as Archegos’ [[prime broker]]s ably proved.

But in any weather, up until the early 1980s, you were either a customer or an intermediary and the above was all quite well settled. But innovations in the market, technology and regulation began to change things.

The [[swap  history|history of swaps]] is interesting and fairly well-documented. It all started in earnest in 1981, with a bright idea [[Salomon Brothers]] had to match up IBM, who needed U.S. dollars but had a load of Swiss francs and Deutschmarks, with the World Bank, which had all the dollars anyone could need but needed to meet obligations in CHF and DEM which it wasn’t able to borrow. The two institutions “swapped” their debts, exchanging dollars for the European currencies and paying [[coupon]]<nowiki/>s on them, with an agreement to return the the same values of the respective currencies at maturity.

Everyone else recognised this to be a cool idea, and before you know it, swaps trading was a trillion dollar industry. Okay; this took a bit of time, but in the geological history of finance from the time of Hammurabi, it was the blink of an eye. But anyway, note a few things:

Unlike traditional banking activity, swap transactions are ''bilateral''.  In one sense, ''both'' parties were lending to each other — hence they were not just parties, but “''counter''parties”.<ref>Or maybe this just means they sat at a counter. This has just occurred to me. Why not? These are [[OTC|over-the-counter]] derivatives, after all.</ref>  In another sense, ''neither'' was: as long as you could [[Set-Off|offset]] the swapped loans, at inception a swap trade was market neutral: each “lent” the other something of equal value.<ref>Law students will know this notion of enforceable set-off is a tricky one, especially if you are trading across international markets, where insolvency regimes are capricious, and might struggle to understand it, in a way they tended not to struggle with ordinary secured lending. Hence the great, tedious topic of [[Close-out netting|netting]], which isn’t wildly germane to this essay except to point out that [[Credit risk mitigation|credit mitigation]] for swaps by set-off, not security, and credit risk can swing around, depending on the market value of the underlying obligations.</ref>